In recent years, the appropriate level and structure of interest rates have come to be seen as major issues in connection with stabilization programs undertaken by members. These issues arise from consideration both on the demand side, as interest rates affect the magnitude of aggregate demand, and on the supply side, as they influence the volume and quality of investment and, thus, the growth of output. Attention has also been drawn to interest rate issues by the success achieved in certain countries carrying out programs of financial reform involving adjustment of interest rates.
In any economy in which decisions by individual economic units play a major role, interest rates perform several important functions in which they influence a broad range of economic decisions and outcomes. In this respect, interest rates are similar in scope to the influence of other economywide prices, such as the exchange rate and the basic wage rate.2
Interest rates can have a substantial influence on the rate and pattern of economic growth by influencing the volume and productivity of investment, as well as the volume and disposition of saving. This is especially true for countries where financial markets are relatively well developed or where private investment constitutes a significant share of total investment. Even in countries with less developed financial markets or in those where investment is overwhelmingly the responsibility of the public sector, interest rates may have a significant effect on the mobilization of household savings and on investment decisions. In analyzing this set of issues, it would be useful to distinguish between the effects on saving and those on investment, bearing in mind, however, that while the volume of new investment that can be undertaken is related to the amounts of both foreign borrowing and domestic saving out of current income, it is domestic saving that is by far the more important source of investment financing in most developing countries. Finally, both the savings and investment aspects of interest rate policies influence income distribution, which is treated in the last part of this section.
In recent years, the appropriate level and structure of interest tates have come to be seen as major issues in connection with stabilization programs undertaken by members. These issues arise from consideration both on the demand side, as interest rates affect the magnitude of aggregate demand, and on the supply side, as they influence the volume and quality of investment and, thus, the growth of output.
The bearing of interest rate policies on saving and investment decisions has been discussed in the previous section within the context of economic growth. Equally important is the effect of interest rate policies on macroeconomic stability. Although the primary impact of interest rates is on the financial sector, interest rates, like wages and exchange rates, also exert a substantial influence on aggregate output and employment, real investment, and other real economic aggregates.
(1) Interest rates are an important element in determining the demand for domestic financial assets, the levels of domestic saving and investment, and the current and capital accounts in the balance of payments. Their importance varies among developing countries, however, because of differences in the degree of development of financial markets, the degree of separation of saving and investment decisions, and the extent of freedom permitted to inward and outward capital movements.